When Robert Arnott was deciding whether to start his own investment firm, he met with his hero John Bogle for dinner
When Robert Arnott was deciding whether to start his own investment firm, he met with his hero John Bogle for dinner.
At a steakhouse in downtown Philadelphia in 2001, the founder of the indexing powerhouse The Vanguard Group Inc. spoke with enthusiasm about running his own firm. Mr. Bogle, who now is 82, told Mr. Arnott that starting a company can be rewarding once your investing ideas catch fire.
Mr. Arnott, 56, said that Mr. Bogle inspired him, and he set up Research Affiliates LLC less than a year later. Mr. Arnott, the firm's chairman, went on to shake the foundation on which the older man built Vanguard: indexing that allocates equities based on market capitalization.
Mr. Arnott in 2005 began using a new type of indexing that uses fundamental measures such as cash flow to pick stocks, a methodology that the father of indexing would later denounce as “witchcraft” because of its similarity to active management and its higher costs. By this year, however, the innovator's brand of stock indexing had produced better returns than Mr. Bogle's.
The PowerShares FTSE RAFI U.S. 1000 Portfolio Ticker:(PRF) exchange-traded fund, which is based on Mr. Arnott's methodology, advanced at an average annual rate of 5.3% from its inception Dec. 19, 2005, through May 9. That beats the flagship Vanguard 500 Index Fund's Ticker:(VFINX) 3.2% return, according to data compiled by Bloomberg.
Armed with those results, Mr. Arnott is planning to stir up the world of bond funds.
BOND INDEXES
As Europe and the United States struggle with record deficits, Research Affiliates is building a new set of bond indexes that shun the world's most indebted nations and favor developing economies with smaller obligations.
“Fundamental indexing in bonds may very well be bigger than in stocks,” Mr. Arnott said. “We're looking now at how a debt burden affects gross domestic product and capital markets, and it paints a pretty scary picture.”
Economists and money managers, including Clifford Asness, founder of AQR Capital Management LLC, a $38.8 billion hedge fund, have derided Mr. Arnott's indexes.
“Rob's a good guy; he's very smart,” said Mr. Bogle, who retired as Vanguard's chairman and chief executive in 1996. “He has beaten the market over the past five years, but one might want to think about what goes into that: risk.”
In his office, where he keeps a first edition of Adam Smith's “The Wealth of Nations” from 1776, Mr. Arnott said that he enjoys dueling with his adversaries.
“I thrive on the controversy,” he said. “Intellectual sparring is wonderful fun.”
Mr. Arnott has some of the biggest names in money management on his side in the debate over fundamental indexing. Bill Gross and Mohamed El-Erian, the co-chief investment officers of Pacific Investment Management Co. LLC, are so enamored of Mr. Arnott that he is the only outside fund manager they use.
Pimco also is one of more than 20 firms, including The Charles Schwab Corp., that pay Research Affiliates a licensing fee to use its fundamental indexes. These firms apply Mr. Arnott's strategy to funds with more than $54 billion in assets.
Mr. El-Erian said that criticism of Mr. Arnott that he practices active management in the guise of indexing is beside the point.
“The key issue is, rather than be benchmark-centric, any investment manager should be assessed using three criteria,” Mr. El-Erian said. “How have they performed in an absolute sense, how have they done relative to peers, and how have they performed relative to an index?”
By these measures, Mr. Arnott is succeeding, with his funds doing well for investors and beating benchmarks, Mr. El-Erian said.
Mr. Arnott's next undertaking — fundamental indexes for bonds — is in line with Pimco's outlook of a prolonged period of subdued returns in developed nations due to record levels of debt. He has maintained that view even as stimulus measures by the Federal Reserve have helped U.S. stocks to almost double through May 9, from a March 2009 low.
ARNOTT'S 3 Ds
To design his new bond indexes, Mr. Arnott is collecting and testing data using computer models, going back as far as five decades for the United States and about a quarter of a century for 40 other countries. His aim is to map the relationships between capital market returns and what he calls the “three Ds”: deficits, debt and demographics.
Nations with higher levels of debt and aging populations, such as Japan and the United States, will produce lower returns than countries such as China, where debt and deficits are under control, Mr. Arnott said.
“The only growth we've had in the last decade in the U.S. is deficit spending, which is unsustainable as a source of prosperity,” he said.
Mr. Arnott's bond indexes make investments based on measures of a borrower's health, such as GDP, assets available to service debt, a nation's land mass and energy consumption. So far, just one firm has licensed his bond index.
Last year, Invesco Ltd. converted an existing exchange-traded-bond fund into the new PowerShares Fundamental High Yield Corporate Bond Portfolio.
The fund returned 8.9% from Aug. 2, when Invesco made the switch, through May 9. That is less than the 11.7% increase in State Street Corp.'s SPDR Barclays Capital High Yield Bond ETF, which tracks the cap-weighted index of junk bonds.
